Purpose of Loan
loan purpose is the underlying reason an applicant seeks a loan or mortgage. Lenders use loan purpose to make decisions on the risk and what interest rate to offer. For example, if an applicant is refinancing a mortgage after having taken cash out, the lender might consider that an increase in risk and increase the interest rate that is offered or add additional conditions. Loan purpose is important to the process of obtaining mortgages or business loans that are connected with specific types of business activities.
Pertaining to mortgages and their risk-based pricing factors, the loan purpose factor is sub-categorized by purchase, rate and term refinance and cash-out refinance. Lenders assess that a purchase loan contains the least amount of risk and thus ‘price’ purchase loans most favourably (i.e. no interest rate increase or a risk-based pricing improvement in the order of .25%).
Rate and term refinances are priced similar to purchase loans, with no interest rate increase. Cash received by the borrower at closing may not exceed $2000 to maintain rate and term status. The purpose is, as the name implies, to reduce the interest rate, payment, and/or overall term of the mortgage.
Cash-out refinances are deemed to have a higher risk factor than either rate & term refinances or purchases due to the increase in loan amount relative to the value of the property. Risk-based pricing typically mandates a .25% to .5% increase in interest rate if a borrower needs to draw equity out of the subject property.
Consolidate debt to pay off bills
Consolidating debt is one major reason to borrow a personal loan. This approach can make sense if you’re able to secure a low interest rate. If you pay your other debts with the money from a personal loan, you’ll only have one fixed monthly payment, and you might be able to save money on interest.
Cover unplanned emergency expenses
While it’s best to build an emergency fund to cover unexpected expenses, an emergency personal loan can help if you’re not yet prepared.
Make necessary home repairs
While you might have a wish list of home updates, you might only consider a personal loan for emergency issues impacting your health and safety.
Source of Repayment
Primary Source: The primary source of repayment should be directly related to the kind of loan given i.e. for facilities extended (overdraft) for working capital or to finance trade the repayment should be from the proceeds of the goods sold. If a bridge loan prior to the final allotment of a public issue has been given, the repayment should be from the monies received after the allotment is made. On the other hand if the bridge loan is given prior to the sale of an asset, the proceeds from the sale of the asset should be used to extinguish the loan.
Secondary Source: Even though there may be a real and quantifiable first source of repayment, there is always a possibility that on account of occurrences beyond the borrower’s control, the loan cannot be repaid from the primary source. A classic example is what is presently happening in India on account of the liquidity crunch and the demand downswing. A well-known company purchased 41 windmills at a cost of around Rs. 1 crore each and was confident of selling them quickly. Due to a credit squeeze the windmills were unsold and the company could not repay the borrowings from the proceeds of the sale. The company in order to meet its credit commitments sold some property it owned. This was its secondary source of repayment. When companies take working capital finance in the form of overdrafts, they normally hypothecate debtors and stock. If repayments are not made, the secondary source of repayment can be seized and sold and the proceeds can be used to liquidate the loan.
Tertiary Source: The tertiary source is further security for a loan. This is in the form of additional collateral that may be unconnected with the business. A director could pledge the shares that he owns in certain blue-chip companies as additional security. Alternatively, the principal shareholders could give their personal guarantees or a well-wisher could give his guarantee. The comfort that a Bank would derive is that should the primary and secondary source of repayment fail, they will have recourse to yet another source of repayment. It is assurances such as these that help the Banker in supporting and recommending a request for a credit facility.
The term collateral refers to an asset that a lender accepts as security for a loan. Collateral may take the form of real estate or other kinds of assets, depending on the purpose of the loan. The collateral acts as a form of protection for the lender. That is, if the borrower defaults on their loan payments, the lender can seize the collateral and sell it to recoup some or all of its losses.
If a borrower defaults on a loan (due to insolvency or another event), that borrower loses the property pledged as collateral, with the lender then becoming the owner of the property. In a typical mortgage loan transaction, for instance, the real estate being acquired with the help of the loan serves as collateral. If the buyer fails to repay the loan according to the mortgage agreement, the lender can use the legal process of foreclosure to obtain ownership of the real estate. If a second mortgage is involved the primary mortgage loan is repaid first with the remaining funds used to satisfy the second mortgage. A pawnbroker is a common example of a business that may accept a wide range of items as collateral.
The type of the collateral may be restricted based on the type of the loan (as is the case with auto loans and mortgages); it also can be flexible, such as in the case of collateral-based personal loans.
Marketable collateral is the exchange of financial assets, such as stocks and bonds, for a loan between a financial institution and borrower. To be deemed marketable, assets must be capable of being sold under normal market conditions with reasonable promptness at current fair market value. For national banks to accept a borrower’s loan proposal, collateral must be equal to or greater than 100% of the loan or credit extension amount. In the United States of America, the bank’s total outstanding loans and credit extensions to one borrower may not exceed 15 percent of the bank’s capital and surplus, plus an additional 10 percent of the bank’s capital and surplus.
Reduction of collateral value is the primary risk when securing loans with marketable collateral. Financial institutions closely monitor the market value of any financial assets held as collateral and take appropriate action if the value subsequently declines below the predetermined maximum loan-to-value ratio. The permitted actions are generally specified in a loan agreement or margin agreement.
Types of collateral loans.
No guarantor is required for such a loan since the car itself acts as a security with the lender. A typical car financing arrangement is different from a loan against a commercial vehicle. A car financing arrangement is executed at the time of purchase of the vehicle; the proceeds are purely utilized for the purchase of the vehicle only. The borrower is free to use the vehicle for any purpose. However, commercial vehicles cannot be used for personal use by the borrower, who has to have an existing business to be eligible for the loan.
Loan Against Securities
A loan against securities is an extension of an overdraft facility by the financial institutions. The financial assets like shares, bonds etc. act as collateral with the lender, against which the borrower is issued a limit. The borrower can then take short term loans within this limit.
Loan Against Property
A loan against property financing arrangement includes a loan taken from a financial institution with no restriction on its use by the borrower. The existing house property is kept as collateral with the lender as a security against a probable default by the borrower. Whereas, A typical housing loan financing arrangement is to facilitate the purchase or construction of a new home and the proceeds are to be used for that purpose only.